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Bad tidings

Created:
7 January 2008
Written by:
Simon Thompson

Henry Kaufman, chief economist at Salomon Brothers once said: "I never felt good about being called Dr. Gloom, but I never worried about it either, because I think you should try to say it as it is. You're not in a popularity contest here."

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He had a point, and it's one that I adhere to. So though it's good to be back after an extended holiday Down Under, there is no getting away from the fact that I am the bearer of bad tidings. In fact, given the rapidly deteriorating outlook for both the UK and US economies, and the fall-out from the credit crisis, I am now more bearish on the outlook for equities than at any time in the past five years.

Contagion: Credit default swaps

My main concern is that there is a real chance that the contagion from the sub-prime crisis in the US - which has led a freezing up of money markets, a massive contraction in the asset backed commercial paper market and far tighter lending practices in the banking sector - will lead to a domino effect across several other financial markets. For instance, we have yet to see the fall-out from the market in credit default swaps issued on the defaulting sub-prime mortgages in the US. These are derivative instruments that work like insurance policies on sub-prime residential mortgage-backed securities, or on the collaterised debt obligations (CDOs) that hold them.

The problem is that investors holding the credit default swaps will start making calls, and increasingly so this year, on these insurance policies as their losses on the underlying mortgages increase. And to make matters worse the liabilities that have been underwritten by these credit insurance policies could in certain parts of the market be greater than the actual losses on the sub-prime mortgages themselves. For example, analysts at UBS Investment Research estimate that CDOs sold credit protection on around three times the actual face value of triple-B-rated sub-prime bonds. In other words, instead of diversifying the risk of householders defaulting on their mortgages, these swaps are actually magnifying the losses. So with experts forecasting that the total physical losses alone from the sub-prime crisis could end up at anything upto $500bn (£253bn), there is in effect a ticking time bomb that is waiting to explode across the finance industry.

To make matters worse, the bond insurers underwriting the insurance policies are now facing credit rating downgrades themselves. For example, late last month Standard & Poors credit rating agency slashed their rating from ‘A’ to ‘CCC’ on ACA Financial Guaranty Corp - a company that underwrote an eye-watering $20bn of credit protection in a six month period last year. Downgrades not only make it difficult for bond insures to raise new capital, but in the worst case scenario some may even struggle to meet all their counterparty liabilities if defaults escalate. Needless to say the collapse of a major bond credit insurer would have serious ramifications as it would trigger significant losses at financial institutions and hedge funds that previously thought they had credit protection in place having entered into these credit default swap agreements on their sub prime books. In my opinion, the insolvency of a bond insurer is the greatest risk to global equity markets in the first half of 2008 as it could lead to a chain reaction whereby institutions, facing margin calls on the money borrowed against defaulting sub-prime mortgage books, are forced to sell their most liquid assets - equity holdings - to meet these calls. Interestingly, the hedge fund industry, which healthily outperformed the major equity markets in 2007, could be vulnerable.

Recessionary Risk

My second concern is that the pain being suffered by consumers on both sides of the Atlantic - deteriorating housing market and squeeze on disposable income through significantly higher energy prices and mortgage bills - could see them rein in expenditure to such a degree that both the UK and US slip into recession. With this thought in mind, economist James Hamilton notes that all bar one of the US recessions in the past 60 years have been preceded, typically with a lag of nine months, by a dramatic rise in the price of petroleum. So if history is any guide, the near-doubling of crude oil prices in the past 12 months has set the stage perfectly.

In turn, this would lead to an escalation of defaults in the leveraged corporate bond market. Currently defaults in the corporate sector are historically very low, but with the US and economies slowing sharply and inflationary pressures set to contrain the Bank of England’s and Federal Reserve's ability to cut interest rates to stimulate growth, then investors are set to remain very nervous until there is clear evidence that both economies are heading for a soft landing. This will take time to play out, making the first six months of 2008 a volatile period for equity markets on both sides of the pond.

True, valuations in the UK don't look stretched with the FTSE All-Share trading on 12 times earnings estimates. Furthermore, with overseas earnings constituting more than half the profits of FTSE 100 blue chips (the index accounts for over three quarters of the weighting in the All-Share index), and sterling under pressure as its yield support reduces - the Bank of England has made it clear that base rate is now on a down cycle to stimulate a slowing UK economy - then we also have a prop to the ‘e’ in the PE ratio. However, that will count for little if investors are worried about the earnings outlook and the solvency of financial institutions.

Furthermore, there is growing evidence that the contagion from the sub prime crisis is going to get worse before it gets better as consumers struggle to refinance fixed rate mortgages given the tighter lending criteria and hike in money market rates in the past six months. In fact, mortgage rates are now running at a seven year just as household energy costs are about to rise steeply following the surge in oil prices to $100 a barrel. And let's not forget that the credit crunch is taking place at a time when house prices and personal borrowings in the UK are at a record level, so we also have to factor into our earnings outlook the real chance of a significant negative wealth effect on consumption from a deflating housing market.

In the circumstances, the spate of bad news emanating from interest rate sensitive sectors - last week we had a downbeat trading statement from high street and catalogue retailer Next and profit warnings from sofa retailer Land of Leather and DSG - the owner of PC World and Currys - is understandable, although a worrying harbinger of things to come. That spells further bad news for the FTSE 250 index which has already fallen 16 per cent from its all-time of 12,282 reached in May last year. As the mid-cap index is stuffed full of cyclicals in the support services sector, general retailers facing a deteriorating trading backdrop, speciality financials, asset managers and investment companies (all geared plays on the direction on the market), the chance of this index officially going into bear market territory - a fall of 20 per cent - looks increasingly likely.

History Books

Unfortunately, our history books also point towards further falls in the Eurozone and US equity markets this year.

To recap, in my article Dow Theory, (9 July 2007), I noted that since the Great Depression not a single one of the five bull markets in the Dow Jones Industrial Average that started in the second year of the decade has lasted beyond the seventh year of the decade. Therefore, unless the five year bull market in the US - running from October 2002 to October 2007 - is about to defy 75 years of history, then the 14,198 record high on the Dow, hit on 11 October last year, probably marked the end of the bull market. What's more, we know that the minimum correction from peak to trough has been at least 17 per cent once previous US bull markets have ended. That would take the index down at least another 1000 points from its current level.

Also, the dramatic rise in market volatility is a major worry. Indeed, since the end of November the UK market has moved from peak to trough intraday by at least one per cent in 20 of the 24 trading days. It not widely known, but research from stock market historian David Schwartz shows that in the past 36 years there have been eight other occasions when the market moved so violently (taking periods when there was at least one per cent price intraday movements 20 times over a period of 40 trading days). Worryingly, this volatility was also accompanied by dramatic falls in the market of at least 17 per cent peak to trough in every single one of these eight periods.

It’s also worth noting that falls in the UK market every month over the period June to August is not only rare, but historically has been during periods of significant market weakness. In fact, prior to last summer, there were only eight periods when the UK stockmarket had fallen during each of these three months since 1945. Unfortunately, in all of these years the equity market was undergoing a correction of at least 18 per cent. To put this into perspective, if history is going to repeat itself, then the FTSE All-Share Index - which peaked out at 3490 on 18 June 2007 - would have to fall to a minimum of 2861, which is 11 per cent below its current level.

Investment Strategy

In the circumstances I think it is prudent to take out some form of portfolio insurance to protect ourselves. The product I have in mind is a listed SG Securities CFD on the FTSE 250 index, C433 (see www.listedcfds.com). This product runs through to 11 July 2008, has a guaranteed stop loss of 12,550, a stop loss of 12,500 and has a contract size of one CFD per point in the index. So with the FTSE 250 trading at 10,200, the CFD is priced at 2,582-2,584p on a tight two point bid offer spread to give it 2350p of intrinsic value (calculated by subtracting the market price of 10,200 from the guaranteed stop loss of 12550) and 234p of time value to reflect the fact that, as we are shorting the index, we have to incur the cost of paying out dividends on the constituent companies. True, it is also leveraged, so a one per cent price movement in the underlying index results in a 3.8 per cent move in the CFD. Therefore, any rally in the mid caps would magnify our losses just as any fall in the index would magnify the gains.

The benefit of this CFD product is three fold. For one there is no chance of being stopped out as the stop loss has been set way above the index’s record high. Secondly, the product gives us six months for the market correction of 2007/8 to fully unfold so time is on our side. And finally, this is a very liquid instrument with a normal market size of 10,000 units. So on the basis that the lows of 10,120 from last autumn give way, as seems likely given the deteriorating sentiment, I have set a price target of 9,000 by expiry in July this year. If reached the CFD would expire at 3,550p, or 37 per cent above its current level.

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